BlackRock Inc., which controls 42% of the exchange-traded-fund market, is calling on its peers and regulators to raise their standards in terms of transparency and oversight of ETFs.
While a report issued by the company Oct. 5 includes five areas of recommended reform, BlackRock has placed particular emphasis on a reduction in the use of synthetic strategies, which don't hold the underlying investments. The reliance on derivatives and futures contracts to replicate the exposure of an index or asset class introduces risks associated with “mistracking as well as counterparty risks,” according to Jennifer Grancio, managing director and head of BlackRock's iShares U.S. distribution.
She acknowledged that as the ETF industry has expanded — it now includes more than 1,300 funds and more than $1 trillion under management — there are some strategies that would be difficult, if not impossible, to employ without the use of synthetic strategies.
In the commodities space, for example, it would be impractical for a fund manager to own the physical commodities represented by many ETFs, which is why gold and silver ETFs are among the few exceptions in terms of holding the underlying assets.
Of the more than 460 iShares funds globally, “only a handful use synthetic strategies,” Ms. Grancio said.
And of those, “we are undertaking a review” of whether it would be possible to start holding the underlying assets, she said.
“We believe, where possible, holding the physical securities is preferred,” Ms. Grancio said. “And where that is not possible, we are moving to the highest level of collateralization and disclosure.”
Robert Goldsborough, ETF analyst at Morningstar Inc., Chicago, praised BlackRock for “showing some leadership in the ETF space.”
That said, the imposition of higher standards would mean that “everyone in the industry has to agree on this,” he said.
Although most ETF providers already post expense ratios on websites, BlackRock is recommending that the industry adopt uniform global standards of fee disclosure.
Mr. Goldsborough is particularly supportive of BlackRock’s recommendation that all fees and costs — including those paid to counterparties — be disclosed to investors.
“For a long time, we’ve felt that investors should have a better understanding of the costs, and uniform global standards are a great idea and long overdue,” he said.
In addition, BlackRock also is recommending clear labeling of product structure and objectives, frequent and timely disclosure of all holdings, standards for diversifying counterparties and uniform trade reporting for all equity trades.
“ETFs were structured a lot differently in 1990s than the ones coming out today,” Mr. Goldsborough said. “I think there is definitely some investor confusion out there.”
Even if the BlackRock recommendations sound good in theory, some in the industry said that it would be nearly impossible to implement them on a global scale.
“There are certainly a bunch of us in that [ETF] space, and some of the unique structures don't lend themselves to be easily understood by investors,” said Mark Roberts, director of research and development at Russell Investments, which is a relatively small player with $200 million in 21 ETFs.
The increased demand from investors for different kinds of market exposure through ETFs will lead to more-elaborate and often synthetic structures, he said.
“ETFs are pretty heavily regulated already, and I'm not sure exactly who would be able to enforce these kinds of global standards,” Mr. Roberts said. “I'm actually scratching my head a bit as to why anyone would go for such a broad call for standards.”
Jeff Benjamin is a senior editor with InvestmentNews, a sister publication of Pensions & Investments.